Much is made of the use of leverage in trading to increase returns on both investment and trading portfolio’s. But what exactly is leverage and how can we use it effectively to improve our returns? The big issue that is usually highlighted but little understood is that leverage is a double edged sword. Just as it can be used to improve our returns, leverage can also have catastrophic results for those that fail to understand its use and effective implementation.
Leverage is the use of a derivative product that allows you to control a much larger chunk of a particular stock or commodity than would be possible using all your own cash. A futures contract for example allows you to trade large amounts of a commodity for a fraction of the cost of the underlying contract value. Share CFDs and options are similar in that they allow you to have exposure to more shares for a fraction of the outlay.
Leverage occurs whenever money is ‘geared–up’ to make a larger investment in a market. The larger investment and associated potential returns would not be possible without the loan. An everyday example that we are all familiar with is borrowing money to buy a house in the real estate market.
Example: John buys a house for $500,000 using $100,000 of his own money and a loan of $400,000 from the bank. He has leveraged his own money by a factor of 5 to acquire an investment he could not otherwise afford.
In the financial market leverage can be created through leveraged instruments such as a CFD, option, or futures contract. Each one may have a different leverage factor but the principle is the same. Financial institutions, including Banks, Brokers and Market Makers, are all providers of these instruments and will set their own characteristics for each. Trading using leveraged instruments is different to trading on margin. We will discuss the use of margin loans in another Blog.
Any investment using a leveraged instrument requires a financial contribution from two parties. The previously mentioned loan usually forms the largest percentage and comes from the provider. The remainder is made up with your money and is termed the initial margin, initial deposit or simply margin.
You must be totally aware that leverage comes with greater risk. If the value of the larger investment moves against you, your absolute loss is much greater than it would have been without leverage. With some leveraged instruments you could lose more than your initial margin. Leverage magnifies both gains and losses.
Example: John buys $100,000 face value of shares in XYZ using CFDs with a 10% deposit or $10,000 of his own money. He effectively has a loan of $90,000 from the CFD provider; a leverage factor of 10. The value of XYZ shares fall by 4% to $96,000. He sells the entire position to produce a gross loss of $4,000 or 40% on his original $10,000. John now only has $6,000 to reinvest.
It is therefore critical when trading with leverage that you have a proven methodology in which money and risk management rules control the risk to your portfolio. It is often the case that investors with a small amount of start-up capital are the one’s drawn to the use of leverage like ‘moths to a light’ in an attempt to increase their capital base quickly. Without a thorough understanding of the application and effects of leverage they are unfortunately often adversely affected by the markets because they are too highly leveraged without a true understanding of the consequences.
We spoke with a ‘trader’ only yesterday who couldn’t understand why he was so nervous about a trade he had put on and why he had been so adversely affected by a small price move against his position. This person had a $40,000 trading account with a CFD provider. Using the leverage available he had purchased 50,000 CSR shares at $2.04. This left him with a face value position of $102,000.00. When the price dropped to $1.94, just 10c, he was stopped out of the trade with a loss of $5000.00 or 12.5% of his original trading capital. To put this into perspective, loss trades should be, on average, between 0.5% and 2.5% of the ‘un-leveraged portfolio value’. Those that wish to take large risk might go as high as 5% but 12.5% is on track to portfolio ruin.
The key when using leverage is to understand it properly and to always protect your capital. The lure of big winners through the use of leverage is more often than not tempered by the big potential losses that can occur, such as in the above example.
“Longevity in the world of leveraged trading isn’t measured by how much you make when you’re hot. It’s defined by how little you lose when you’re cold.” Author unknown.
Of course, this applies to all trading but is magnified when trading with leverage.
Next week we will look at some strategies that we employ in the SPACFD trading methodology to effectively manage and control the use of leveraged instruments in the overall portfolio. We will also discuss what type of investor is suited to leverage and what the maximum amount of capital is that an investor could consider to trade with leverage.